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The Next Buyout Stock

Think like a private equity investor, but think for yourself.

Have private equity firms entered their Golden Age? Current numbers are staggering: For the year to date, global LBO volume is approximately half a trillion dollars, more than double the volume for the year-ago period, according to Dealogic, a software and data vendor. In the United States, LBO volume represents more than a third of all M&A activity.

On June 15, for example, shares of Penn National Gaming (NASDAQ:PENN) gained 21% after the racetrack and casino operator announced that it was being acquired by Fortress Investment Group (NYSE:FIG) for $67 a share, a tidy 31% premium to the previous day's closing price.

Sharks in the waterNaturally, many investors are curious to know which company will be snatched up by private equity investors next. To answer that question, take a step back and ask the following question: What types of companies do private equity firms tend to invest in?

These are four primary characteristics of firms that private equity firms seek in potential targets:

1. Steady and predictable cash flowsLBOs -- the 'L' stands for leveraged -- are financed by large amounts of debt. Investors look for companies that will be able to make the associated interest payments by generating healthy, steady cash flows from their operations.

2. Clean balance sheet with little debtDebt boosts the returns of private equity investor returns in an LBO. If a company already has a lot of debt on its balance sheet, it's not a viable candidate.

3. Strong, defensible market positionNo surprise here! A defensible market position is attractive for two reasons: First, it's a key determinant of a firm's ability to generate steady cash flows year in, year out. Second, firms with a defensible competitive position are those that are most likely to compound their intrinsic value. Increases in intrinsic value are another source of LBO investor returns.

4. Minimum future capital requirements.Capital expenditures required to maintain the firm's operations consume cash flow that could otherwise be allocated to other uses. In a company that has been taken private through an LBO, the priority is the payment of interest or principal payments on the new debt. All other things equal, companies with low maintenance capital expenditures can dedicate more cash to servicing that debt.

Private equity is pretty sharpDo these four criteria sound familiar? If, like me, you're a value investor, they might as well be a mantra.

That's not a coincidence: Value investors believe in adopting the mindset of a control investor. After all, if you approach every stock purchase as if you were acquiring the entire company, you're going to look for these traits -- the hallmarks of superior companies -- above all else.

My "potential buyout" screenTo try to find potential buyout candidates, I created a stock screen based on criteria that try to capture the characteristics I discussed above. These are the criteria I used:

Free cash flow margin greater than 12% over the trailing 12 months and for the years 2004 through 2006.

Total debt-to-capital ratio less than 20%.

Capital expenditures to revenues less than 5%.

No investor worth his or her salt wants to overpay, even for a high-quality company, so I added a valuation criteria:

Enterprise Value-to-EBITDA less than 9 (EV/EBITDA is a valuation ratio that is widely used by LBO investors).

Here are four companies that showed up in my screen (with some relevant statistics):

Industry

TTM FCF Margin

Return on Capital

EV/ EBITDA

Pfizer (NYSE:PFE)

Pharmaceuticals

23%

12%

8.2

LAM Research (NASDAQ:LRCX)

Semiconductor Equipment

13%

30%

8.0

King Pharmaceuticals (NYSE:KG)

Pharmaceuticals

19%

15%

6.1

Actions Semiconductor (NASDAQ:ACTS)

Semiconductors

29%

24%

4.1

These aren't recommendations, but they might be worthy of further investigation (in fact, Pfizer has been a Motley Fool Inside Value pick for quite some time). Of course, you might be wondering why I bothered to leave Pfizer on the list. At $180 billion in market capitalization, it's much too large to be the object of a leveraged buyout.

Don't bet on buyoutsAs an individual investor, you shouldn't be buying stocks in the hopes that they'll get bought out. While you'll get a nice short-term gain, you're also leaving future gains on the table. Remember: Private equity will only buy out a company if they think they can get gains far in excess of the buyout price.

So instead of trying to guess where private equity will be stepping next -- which is unlikely to prove financially rewarding -- focus on finding outstanding companies trading at bargain prices. That's what we do at the aforementioned Inside Value service. You can take a look at all of our research and value recommendations by clicking here to join IV free for 30 days.

After all, if you find enough outstanding companies trading on the cheap, private equity will find you.

Alex Dumortier, CFA has no beneficial interest in any of the companies mentioned in this article. Pfizer is an Inside Value recommendation. The Motley Fool has a disclosure policy.